Friday, February 17, 2006

• TD Bank announced yesterday that it has entered into an agreement to acquire VFC, a financial institution in the sub-prime, used auto lending market. The transaction value is $326 million—just under four times tangible book value.

• For this deal to be successful, the people and the processes put in place to originate loans at VFC are crucial. We believe that both are sound. The senior executives have extensive experience and the three senior executive will take stock for 100% of their shareholdings in VFC. In addition, we believe that the process of risk-based pricing by VFC, though untested by a recession in Canada, is robust.

• We are not blind to the risks associated with buying VFC—loan losses can be volatile (to state the obvious), the potential for reputation harm is tangible (lending at over 20% typically doesn’t win anyone friends) and originations and margins can fluctuate.

• We believe that buying a “stand-alone” player in one segment of the market, which seems to have capable management and a good track record, is a reasonable way to capitalize on the opportunity. In this report, we consider the economics and provide a detailed background on VFC, the sub-prime auto business and its operating model. Overall, we consider this a reasonable deal and retain our Outperform rating on TD Bank shares.

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The Globe and Mail, Sinclair Stewart, 17 February 2006

Brimming with cash, but bereft of places to spend it, acquisition-hungry Canadian banks are descending on one of the last apparent markets for growth in domestic retail lending: the higher risk, or "sub-prime," consumer.

Toronto-Dominion Bank entered the fray yesterday, agreeing to pay $326-million for VFC Inc., a Canadian company that provides car financing for buyers with weaker credit profiles.

The larger Canadian banks have steered clear of these consumers, in part because the potential financial reward was not deemed worth their while, and in part because they fretted about reputation damage if they began charging as much as 30 per cent interest on a loan.

But that attitude is changing, spurred by the approximately $10-billion in excess capital the banks are lugging around and the lack of expansion opportunities.

The sub-prime borrowers, or "near-prime" consumers, have suddenly become a sought-after market, and banks are swimming downstream to help them buy cars and homes.

On Tuesday, Bank of Nova Scotia announced a $233-million acquisition of Maple Trust, a mortgage lender that provides financing through an army of brokers.

"It's the last frontier, so to speak, of retail lending in Canada," said Darko Mihelic, a bank analyst with Blackmont Capital in Toronto. "I think banks are going to steamroll this [market] in the next five years. It's only a matter of time before they become the source for all of this stuff."

The sub-prime category, particularly in car lending, didn't really exist five years ago. Today, however, it is estimated to be a $4-billion market, only 25 per cent of which is currently served by existing players such as VFC, Home Capital, and Wells Fargo.

The mortgage market for these consumers, meanwhile, is pegged at about $20-billion. Although Scotiabank has said it plans to target the near-prime borrowers, many analysts believe this will be only a stepping stone to the fatter profit margins of sub-prime lending.

"We believe there is good growth there," said Alberta Cefis, executive vice-president of domestic personal lending and insurance at Scotiabank, which will become the country's number three mortgage provider. "It's an untapped market."

South of the border, and in the U.K., non-prime lending accounts for about 30 per cent of the entire retail lending market. In Canada, by contrast, it remains in the low single-digits, but is growing much faster than conventional lending.

Tim Hockey, who heads up personal banking at TD Canada Trust, said profit margins remain strong in this category because the large banks have traditionally ignored it. He said his bank is also considering a move into this area of the mortgage business.

"That is clearly another strategic push that is under consideration," he said in an interview, pointing out that the management at VFC should help TD learn more about servicing these customers in other areas. "This is a consumer segment we have not touched."

There are still questions, though, particularly around the credit environment: the banks are moving into this sector while rates are historically low and credit quality is atypically high. Executives at VFC acknowledged yesterday their relatively young company has never experienced a sustained downturn, which could lead to fewer purchases and more frequent defaults.

While default rates are much higher for non-prime borrowers, so are the interest payments (they range from 13 per cent to nearly 30 per cent) which has allowed VFC to mitigate its exposure.

And these borrowers are not all high-risk: many are immigrants, who arrive in Canada with no credit histories, no banking relationships, and no hope of qualifying for a conventional mortgage or car loan at a branch.

"We want to make sure we're the bank of choice for new Canadians," acknowledged Mr. Hockey. "I'd say [the industry] is not very good at recognizing their needs."

VFC's performance over the past five years illustrates the appeal of non-prime lending for banks: profit has grown steadily from $2.7-million in 2001 to $11.2-million last year, while its portfolio of receivables has jumped from $72-million to $380-million.

The real opportunity is in the area of funding: TD has a much cheaper cost of capital than a small player like VFC, which should help it boost its margins immediately. It's an attractive model for other banks inclined to slide into the sub-prime sector, and analysts like Mr. Mihelic believes others will soon follow.

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The Globe and Mail, Andrew Willis, 17 February 2006

With the sale yesterday of car lender VFC, Sprott Securities completed one of tidiest pieces of cradle-to-grave advisory assignments you'll ever see on the Street.

Back in 2003, Sprott demonstrated its small-cap, special situations focus by taking VFC public at $6.50 a share. (The other lead brokerage house on that offering was TD Securities.)

VFC extends credit to those 18-year-olds who flip burgers, just have to drive a '79 Camaro, and can't get a bank to advance them a cent. Done with skills that include the occasional repossession of used muscle cars, making the loans that banks won't touch is a great business. VFC built a $380-million loan portfolio with 25,000 clients -- or an average loan of $15,200 per customer.

Yesterday, Toronto-Dominion Bank swooped in with a friendly deal to buy VFC for $326-million or $19.50 a share. That's three times the IPO price in less than three years. The adviser that helped VFC end its days as an independent company was Sprott Securities, which has been building its merger and acquisition expertise. On the other side of the table, TD Securities was there to advise TD Bank on the purchase.

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Canadian Press, Gary Norris, 16 February 2006

TD Bank Financial Group is jumping into the business of making high-interest loans to used-car buyers with dodgy credit ratings by taking over VFC Inc. for $326 million.

TD and VFC announced Thursday that TD is offering $19.50 per share for VFC, whose stock had closed Wednesday at $14.15.

"This acquisition is a logical extension of our existing business as a leader in dealer-based automobile financing and an opportunity for us to increase our range of product offerings in response to what dealers and their customers have said they want," stated Tim Hockey, head of TD's personal banking group.

So-called non-prime consumer lending is "an underserved market segment with significant growth opportunity," Hockey said, telling an investor conference call that the high-risk loan segment "will grow faster than the traditional consumer lending market will, and we want to be at the table."

Charles Stewart, president and CEO of Toronto-headquartered VFC, cited "potential synergies of the two organizations, particularly with regard to referrals and distribution," and observed that the TD bid "represents an attractive value proposition for our shareholders."

VFC shares jumped $5.15 or 36 per cent to $19.30. The company, founded in 1994, went public in October 2003 at $6.50 per share - exactly one-third of TD's offer price.

VFC, with offices in Toronto, Montreal and Nanaimo, B.C., has 220 employees and $380 million in receivables from more than 25,000 customers lined up through relationships with 2,000 car dealers.

Auto loans are 95 per cent of its portfolio and Stewart said 95 per cent of these loans are for used vehicles, typically two to four years old, with about half of the transactions originating from new-car franchised dealers and half from independents.

VFC will continue under its own brand and management and Stewart said he and other top executives are committed to stay with the company for at least three years.

VFC stockholders have the option of taking $19.50 per share in cash or $19.45 per share in TD common stock plus a nickel per share in cash.

The offer is endorsed by the VFC board, and management and other shareholders owning 29 per cent of the company have entered into lockup agreements to tender their stock.

Among those shareholders is Manulife Financial Corp..

The arrangement includes a $9.25-million break fee if VFC reverses its acceptance.

VFC connects to dealers via the Internet and Stewart said it turns around loan decisions within 10 minutes using a combination of computerized screening and human decision-making.

Last month it struck a deal with Chrysler Financial under which customers who don't qualify for loans from the automaker are automatically forwarded to VFC.

VFC earned $3.5 million on revenue of $20.4 million in its latest reported quarter, up from $2.2 million on $15.2 million a year earlier.

Colleen Johnston, TD's chief financial officer, said VFC's business is forecast to grow at 20 per cent or more annually "before the benefit of referrals from TD." The bank expects the transaction to start adding to its earnings next year.

Dominion Bond Rating Service observed that keeping VFC as a separate brand will "clearly delineate between the higher-risk lending operations and TD's own lower-risk prime auto lending business."

VFC's business - lending to people who have undergone financial problems, have brief credit histories, or are self-employed - provides high interest margins but also high loan losses, DBRS analysts Robert Long and Brenda Lum noted.

"While the portfolio is higher-risk in nature, associated credit risks are manageable," they added, estimating that VFC's portfolio amounts to only 0.2 per cent of TD's total consumer loans.

VFC's Stewart told analysts - who congratulated him on a great deal for his shareholders - that the company has "always been constrained by the cost of capital," which will be reduced as a unit of TD, likely by two or three percentage points, analysts estimated.